Equity markets have long been considered a good measure of the economy, however, given the current divergence between the market and the economy following the 2020 Coronavirus pandemic, it is quite evident that that any market that seeks to measure the economy, be it the S&P 500 or the DOW, is but a reflection of that economy, and reflection that is painted by the powers and interests of the markets’ participants, a tainted representation of the economy.
Understanding the powers and interests of the participants that influence the equity markets is a complex, imperfect science and hence deceptively hard. However, we can choose to understand the foundation upon which the markets are based, the economy, the basis of image that the markets reflect.
To understand the economy, I have built a metric that looks at three foundational of the economy: Debt, Production (GDP) and Employment. To understand the relationship between these driver I use a ‘Comparitive Change Measure’, which as used in this report, is one that compares the growth or decline in one metric with the growth or decline in another complementary metric.
Let’s begin by comparing Debt and GDP for example. If the economy takes on $1 trillion in new debt and creates $1 trillion in additional GDP, the ‘Comparitive change measure,’ measures the difference between the change in GDP and the change in Debt which results in a measure of 0. Consequently, if GDP increased at a faster rate than Debt, which implies that the economy is getting stronger and produced more with much less additional debt, the metric would be positive. A negative number indicates that Debt has grown faster than GDP, which while not necessarily bad, if continued over long periods of time, can be harmful to the economy. These measures are calculated over a period of one quarter.
Calling the comparitive change metric that compares Total Pubilc Debt and U.S GDP as the Debt Indicator, we have this indicator for the last 50 years below:
In the 215 quarters from 1967 to 2020 we have seen GDP increase faster than Debt in just 18 quarters, or less than 10% of the time. While it’s no surprise that Debt has been growing faster than GDP, the relative growth of debt with respect to GDP over the last 25 years, starting in 2001 and really picking up in 2008, causes some alarm and is a clear indicator that despite having GDP expansion it was primarily debt fuelled expansion that has driven the U.S economy. Between Q1 and Q2 of 2020, we see the largest decline in GDP combine with a rapid increase in total public debt to give us the most negative ‘Debt Indicator’ ever measured at -4.3. (meaning a relative differrence of $4.3 trillion this past quarter)
While the Debt indicator is a backward looking indicator and hence should not be considered as a forward looking indicator of where the economy is heading, it can tell us a sense of how good or bad the current economy is doing in comparision to the past and in today’s pandemic world, it can give us a sense of if and when a recovery is underway. Any number below -1.5 indicates rapid debt increase or severe GDP contraction which has occurred only 4 times in the last 215 quarters, twice during the 08-09 Financial Crisis and the remaining two during the past two quarters: Q1 and Q2 of 2020. Suffice it to say that as long as we remain under -1.5 we are still trending strongly negative and not yet in recovery mode.
I shall keep an eye on this metric moving forward to measure the recovery from the current economic recession, when we cross back over the -1.5, -1.0 and -0.5 levels is when I will begin to gain confidence in the direction of the Economy.
A Comparitive Employment Measure:
Debt and GDP are strong measures for the effective use of capital. However, we must also look at another equally important source of growth for the economy, labor. Similar to the comparitive Debt and GDP measure, we look at a comparitive labor employment measure with compares the number of jobs are created, measured in U.S job vacancies, with the number of job cuts, measured in the ‘Challenger’ job cuts data.
A negative number indicates that job cuts are happening at a much faster pace than the growth in job vacancies (a proxy for new jobs), while a positive number indicates that job vacancies are growing faster than job cuts.
Calling this measure ‘The Employment Indicator‘, we see in the chart below the Employment Indicator going back to 2001.
As we can see, from the chart of the employment indicator above, the indicator has passed -1 to the downward side only thrice in the last 20 years: the 2001-2002 recession, the 2008 recession and, the third during the Coronavirus pandemic, when the employment indicator registered its most negative number. The significant drop in the employment indicator is primarily attributed to the sudden loss of jobs due to the pandemic.
For a more detailed understanding of the Debt and Economic Indicator, its assumptions and adjustments please look at [Link]
The Total Indicator
When we combinine both the Debt and the Employment indicator, by simply adding the two, we get a Total Indicator which I believe to be a good measure of the economy.
The Total Economic Indicator goes back to 2001 and currently registers its worst quarterly reading of -8.5 between Q2 and Q1 2020. The combination of instant job losses and production coming to a halt during the pandemic is the main reason for this drastically negative reading following the Q2 2020 data. It is very likely that the next quarter’s reading will be much less negative since it is almost impossible to lose jobs and GDP at a faster rate than that which occurred between Q1 and Q2 of 2020. The level of the Q3 and Q4 reading will tell us if the recovery is V, U or L shaped.
So how does the U.S economy compare with its reflection, the U.S equity market? With the S&P having already gone through a correction in March 2020 and currently nearing its all time highs the market has already baked in an expectation of a V shaped economic recovery. Further, monetary and fiscal stimulus through the monetization of debt by the U.S Federal Reserve in the current economic climate has created an air of uncertainty. For now the Federal Reserve has become the most powerful influencer among all market participants and understanding their interests is key to understanding the markets.
Maneuvering this enviroment requires a portfolio that is not only hedged (protected) from these risks but one that can also take advantage of the opportunities available due to newly printed money injected into the markets and economy.
The Millennial-Gold Portfolio looks to play this current economic and market environment by gaining exposure to precious metals, equity markets and volatilty products accordingly to protect wealth and grow wealth in an uncertain world.